For example, let’s say your accounts receivable balance is currently $11,500, but you’re not entirely sure that you’ll be able to collect the entire balance due. Contra accounts are used to reduce the value of the original account directly to keep financial accounting records clean. This type of account could be called the allowance for doubtful accounts or a bad debt reserve.
Sometimes, it is important to keep the original balance of the accounts and create the contra accounts to be able to calculate the net value of the account. Hence, the term valuation account represents all types of balance sheet accounts related to their corresponding balance sheet accounts. This helps the firms to evaluate the book value of their assets and liabilities.
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One case is when inventory turnover levels are extremely high for all items, so that inventory rarely stays on the shelf for long. Another case is when inventory is so subject to spoilage that older items will probably be thrown out before they https://www.bookkeeping-reviews.com/fill-fate-definition-supply-chain/ could impact the contra account. A good example is a restaurant, where the staff will likely inspect the inventory every few days and throw out spoiled items. There are several situations in which a contra inventory account can be used.
- Inventory is counted as an asset, and inventory reserve is counted as a contra asset, in that it reduces the net amount of inventory assets at the company.
- Contra accounts are used to reduce the value of the original account directly to keep financial accounting records clean.
- For example, an increase in the form of a credit to allowance for doubtful accounts is also recorded as a debit to increase bad debt expense.
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Last, for contra revenue accounts there are sales discounts, sales allowances, or sales returns. These contra revenue accounts tend to have a debit balance and are used to calculate net sales. In response, the firm should decrease its accounts receivable and revenue balances. That is done by crediting accounts receivable by $100 and debiting the contra revenue account sales returns and allowances for $100.
For this reason, contra accounts are primarily seen as having negative balances because they are used to reduce the balance of another account. Contra equity reduces the total number of outstanding shares on the balance sheet. The key example of a contra equity account is Treasury stock, which represents the amount paid to buyback stock. Accountants use contra accounts rather than reduce the value of the original account directly to keep financial accounting records clean. If a contra account is not used, it can be difficult to determine historical costs, which can make tax preparation more difficult and time-consuming.
Understanding a Contra Account
Examples of fixed assets include buildings, machinery, office equipment, furniture, vehicles, etc. The accumulated depreciation account appears on the balance sheet and reduces the gross amount of fixed assets. Normal asset accounts have a debit balance, while contra asset accounts are in a credit balance.
Whenever the balance of a contra asset account increases (credit to the contra asset account), the increased amount is written off as an expense and is reported in the company’s income statement. Both the asset and the corresponding contra asset accounts must be stated clearly in the balance sheet. Usually, the asset account is listed first, and its contra asset counterpart is listed underneath, with the asset’s net value or book value. Note that in accounting, the term “book value” is also used interchangeably with net value.
Key examples of contra asset accounts include allowance for doubtful accounts and accumulated depreciation. Accumulated depreciation reflects the reduction in value of a fixed asset. Sometimes, both accounts can be written in a single line if they don’t represent a large portion of the assets. In case the contra asset account is not listed in the balance sheet, it must be listed in the footnotes of the financial statement for the users to be informed.
A key example of contra liabilities includes discounts on notes or bonds payable. By reporting contra asset accounts on the balance sheet, users of financial statements can learn more about the assets of a company. For example, if a company just reported equipment at its net amount, users would not be able to observe the purchase price, the amount of depreciation attributed to that equipment, and the remaining useful life. Contra asset accounts allow users to see how much of an asset was written off, its remaining useful life, and the value of the asset.
The auditors aim to keep the balances at their adequate levels, but the controller might want to keep them as low as possible to reduce expenses and maximize profit levels. Inventory reserve is an estimation of future inventory spoilage based on the company’s past experiences. Once inventory that is unable to be sold is actually identified the advantages of amortized cost it is written down in official recognition of the loss. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. In other words, accumulated depreciation will be $10,000 each year until the car depreciates to $0 twenty years later.
Do Contra Accounts Have Debit or Credit Balances?
One is when market prices are lower than inventory costs, which will trigger a lower of cost or market adjustment. It is also useful when inventory is quite old or turnover levels are low. A third possible use for the account is when some of the inventory is no longer listed in the bills of material for current products, and so will not be used. Although they all aim at reducing the balance of some type of account, it is useful to have some general foundational knowledge of the different types of accounts.
Namely, inventory accounting allows businesses to assess where they may be able to increase profit margins on a product at a particular place in that product’s cycle. The accumulated depreciation account is perhaps the most common contra asset account used by business owners. Contra asset accounts provide business owners with the true value of certain asset accounts.
Accumulated depreciation
In anticipation of this, the company will create an entry on the balance sheet called inventory reserve. Inventory reserve accounts for the predicted amount of inventory that will not be able to be sold that year. Inventory is counted as an asset, and inventory reserve is counted as a contra asset, in that it reduces the net amount of inventory assets at the company. An inventory reserve is a contra asset account on a company’s balance sheet made in anticipation of inventory that will not be able to be sold. Every year, a company has an inventory that will not be able to be sold for various reasons. The contra asset account, accumulated depreciation, is always a credit balance.